Thursday, March 25, 2010

Something Strange is Afoot in Financial Markets

Sometimes markets do very strange things. When they do, it's always important to figure out why. Right now we have just such a puzzle on our hands, and we have a good theory as to what's going on.This is slightly technical, but we believe very important.

Yesterday, the 10-year swap spread went negative for the first time in history. For those of you outside the financial world, the swaps market is where global banks borrow, effectively, from each other. Right now, if one bank borrows from another for ten years, it pays 3.73%. On the other hand, the U.S. Government currently borrows 10-year money at 3.82%. Banks, in other words, can now borrow more cheaply that the United States of America.

How is this possible? Are AA-rated banks more credit-worthy than the U.S. ? Despite our government's profligacy, this explanation doesn't seem credible. Banks, after, have no ability to print money or tax. If the U.S. goes under, banks would likely get buried first.

The explanation for the phenomenon, actually, is both more subtle and more alarming.

In analyzing any market anomaly , it is always helpful to construct, at least as a thought experiment, a trade that purports to take advantage of that anomaly, and follow through its practical implications. Bear with me here. Right now, we can buy all the 10-year treasuries we want at a yield of 3.82% (they are plentiful, to say the least). We can also, theoretically, finance this trade by borrowing in the swap market (using an interest rate swap) like a bank at 3.73%. This is the kind of trade you dream about, a riskless arbitrage where the long side of your trade is the best credit in the world. 

When there's zero risk, you want to back up the leverage truck. 100:1 gives you a risk-free 11.73%. 200-1 nets 19.73% Yippee! Happy days are here again.

Not so fast. The problem with the constructed trade is that we can't borrow money at Libor flat. Who can, nowadays? Banks! The only entities that can borrow some of their money at Libor flat are banks. Their overall cost of a bank's borrowing is of course a blended rate, subsidized by explicit government guarantees such as the FDIC insurance program, a forest of bailout acronyms, winks, nods, and penumbras. The bank's job is to take that relatively low-cost liquidity and recycle it into the economy, slapping appropriate spreads on it to reflect the specific credit quality of their obligors.

Now imagine that instead of accumulating assets through the practice of loaning money, banks just started accumulating Treasuries. Well, for one, their balance sheets get less risky, which will please the regulators. But other seemingly pleasant things happen as well. With higher quality assets, they can increase leverage! Access lower-cost funding sources! Reduce earnings volatility! All nice things, whose cumulative effect, however, is to squeeze the private sector off the bank's balance sheet in favor or the U.S. government.

So where are the non-government borrowers going to go? To some extent, they go away -- the proportion of non-government borrowers accessing liquidity via the banks ends up shrinking:

Source: Barclay's

Excessive private-sector leverage gets squeezed out, a healthy phenomenon if it sets the stage for a future credit expansion to fund future growth. Remember, these things are cyclical and we will eventually want more private credit.

But what happens if that shrinkage is concurrent with an accelerating expansion in government debt? Government debt is safe in the sense that its repayment will always be screwed out of the taxpayer or a government printing press, but here's the problem. The public sector, well, sucks at allocating capital in ways that fuel economic growth (see: ethanol). Unlike private sector debt, government debt tends to fund the misallocation of economic resources, and as it grows, it stifles the very economic growth that can generate the taxes to repay it.

What we have meanwhile is a classic bubble -- the pustule this time is "riskless" assets on bank balance sheets.

The growth phase of the pustule can be deceptively pleasant. Low-risk, low-volatility earnings streams bolster the prices of financial shares. Plentiful liquidity engineers the illusion of low credit costs - illusion, because credit is rationed by lender caprice, uncertainty, and confusion, rather than price. This gets us to the heart of the matter: why aren't banks lending? Because they are confused and, frankly, terrified. Lots of loans went bad on them, of course, but on top of this, the bank regulators are in complete disarray and are providing little clarity, other than, "You better not screw up, and by the way if you make too much money, we might just take it from you." Welcome to the world of regulation, Obama style.

What we have is the next bubble -- Treasury debt ballooning on bank balance sheets, lending to the government, whose activities distort the allocation of resources and hobble economic growth, crowding out lending to private borrowers, whose activities generate economic growth. The moral outcome is that systemic risk increases even as financial firms appear safer.


  1. Great post - thanks to you and Simina for sharing your research and insight.

    It's a beautifully engineered eternal (money) motion machine... Until it stops.

    Although we all love some good Obama-snark, what are the concrete regulatory changes you think he's actually made relative to the last admin? Seems to me like the principals (except Cox->Schapiro) and policies remain firmly in place...

    Looking into your crystal ball (distributed to all bloggers upon firing-up their wordpresses), how do you see this latest bubble playing out?

  2. Thoughts from a southern banker...

    If the U.S. goes under, we all go under…not just banks. While banks don’t print money or tax, we are part of the private sector even though we are regulated by the government and most banks, like ours, do not have the government as their shareholder although some still do through the Treasury’s investment through TARP. While we don’t print money like the government, well run banks attract private capital which we can invest in loans and investment securities. Some banks just might be more credit worthy than our government at the moment.

    I am not a fan of the term bailout; I believe the TARP investment was just that, an investment, not a bailout, and most banks have repaid that investment and the Treasury has made a profit. As for the government providing a subsidy through the FDIC insurance program - the FDIC is funded by our banking industry, not the government. As a result of the bank failures and the drop in the FDIC fund, banks like mine (not the government) have paid a significant amount into the fund to replenish the losses and we will continue to do so.

    Certainly agree that the level of government debt is alarming.

    As for banks not lending – that is true at some banks but not ours where we increased our loan portfolio by 66% last year.

    The government is not dictating how much a bank like ours can make in profits as we have purposely not accepted TARP funds and we remain a private company.

  3. The credit crisis was the result of four years of monetary policy being too easy, rates too low. This means there’s too much money and it found a home where it artificially inflated prices. That home was in mortgage securities. And the asset it inflated were house values.
    The asset harbor for this money was made easy because the Government promoted home ownership through quasi gov’t guarantees by FNMA and FHLMC. Wall street participated by creating a giant assembly line to handle the product—bundling mortgages securitized packages, selling them into regional banks, and off balance sheet vehicles like SIVs and CDOs. The demand for this paper was so great that mortgage brokers produced product no matter what—we need paper! Therefore places like Countrywide and Golden West lowered credit hurdles because there were not enough real buyers to satisfy demand. Everyone made lots of money (homeowners, Fannie and Freddie, wall street, mortgage brokers) and was happy until the music stopped. When some funds with high leverage ratios could no longer justify there marks on the securities—it only takes a miniscule move for highly leveraged accounts, it set up a downward pricing spiral which wiped out a lot of banks equity levels and caused a private market tightening of liquidity.
    The gov’t stepped in and provided liquidity that the private market would not—TALF – and replenished the banks’ equity through TARP. The gov’t liked this providing liquidity—the FED made $52 billion last year on TALF. And they made all their money back with substantial profits on TARP. So it was a liquidity not a real credit crisis.
    Now they never really addressed the problem—Fannie and Freddie still exist, the gov’t still encourages high home ownership and they made it worse by
    1. Encouraging deadbeats to be made whole—mortgage forgiveness and modification. Therefore the market has never adjusted to REAL asset pricing levels for homes
    2. The used the crisis to increase the size of government from 20-25% of GDP
    3. And they just created a new entitlement which is not even reflected in the 25% numbers because they cooked the books on its real costs

    To finance this they need to borrow amazingly large amounts each week at the auctions of government bonds. Last week saw the first crack in the smooth execution of the auctions as demand (buyers) dropped and rates went up. There is only so much money in the system and they are gobbling it up. The result is that they are crowding out legitimate private borrowers who want to borrow now that the economy is starting to get some legs.
    The result will be that the economic rebound will be less robust than it normally would because the cost of capital is artificially increased by the gov’t. Eventually the gov’t borrowing will hit further roadblocks as buyers become too full of the bonds and seek to diversify. This will set off the next pricing cascade—rates go up, the deficit increases because of financing costs and we have a crisis. How do we get out? The alternatives are:
    1. Slash spending—not likely with this crew. ”we need to create jobs!”
    2. Raise taxes – very likely but that further exacerbates the crowding out of private capital formation and slows growth, kills jobs, lowers gov’t revenues—OOPs!
    3. PRINT MONEY. Easy, problem solved. Except it steal money from people who have saved for their retirement, worked to have equity in their homes, etc—all the people who don’t vote for Obama (or Carter).
    This will create some problems that will be hard to avoid. Taxpayers, savers and workers will be pissed. Plus so will the Chinese, Japanese and everyone else who owns our bonds. So who will Obama blame—the banks, Wall Street, greedy corporations and based on his recent meetings with Netanyahu—the Jews. Enjoy the ride down!

  4. The most critical component of the economy is a smooth functioning financial system that supplies equity and debt funds to credible businesses as well as funds to public sector borrowers. Glass-Steagall addressed this issue and created a separation of commercial from investment banking that provided a very workable system. Then Treasury Secretary Don Regan in the mid 1980’s began the process of dismantling this regulatory environment. The S&L crisis followed as the S&L industry immediately began to invest in assets that were beyond their previously defined area of expertise. It appears that no lessons were learned from this debacle and it was the tax payer that ultimately had to pay for these excesses.

    Both Political Parties continued the dismantling of the regulatory constraints as the politicians were influenced by the heavy pressure coming from the financial sector. I feel the excesses of the past 15 years and in particular the last 10 years were a consequence of no effective oversight of the financial industry by disinterested and demoralized regulators. I do not buy into the argument that great recessions or depressions are inevitable or even necessary. I am fully aware of the economic crashes of 1893 and 1907 but they were before we had a Central Bank which could respond to the excesses that produced those down turns. I am not suggesting that technocrats will always get it right when it comes to the economy but I can tell you that politicians will always get it wrong when it comes to the economy. We were very fortunate in 1933 that FDR created a think tank that was comprised of men who could rise above the political pressures and design a system that in fact could work in all economic environments. As you can see, I am a fan of the Volcker plan.

    I also remember a statement that dates back to the 1980’s that “deficits do not matter”. What kind of bullshit is that? The last 8 years illustrates how flawed that point of view is. We will be living with the consequences of that bizarre point of view for years to come. Fiscal discipline was thrown out the window in 2002 and it will take a better Congress than we have currently to fix this problem.

    As for the health care bill, if you were one of the tens of millions that did not have access to health insurance you would be very appreciative of what has transpired in the last week. Let me tell you that the system of “fee for service” is totally irrational and that is what we are burdened with currently. There are excesses that are built into the system that scandalous. Quite frankly we need to abandon the current system and deal with tort reform so that the unnecessary testing that is now the norm can be ended. Free markets have not worked in health care. Big Pharma spends more on marketing than they do on research. Hospitals are not interested in preventive care as they get much better reimbursement for emergency room treatment. Insurance companies only accept low risk clients and drop those that become high risk. Our healthcare costs represent 16% of the economy and growing to 20% in the next 10 years as contrasted with much lower costs elsewhere in the industrial world where there are better outcomes.

    Needless to say, I could go on indefinitely. We are faced with a mess.